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The California Limited Liability Company -

Is It The Business Structure For You?

November 01, 1999

ADOPTION OF THE ACT

 On September 30, 1994, California enacted the Beverly-Killea Limited Liability Company Act (the “Act”) which authorizes the formation of domestic limited liability companies (“LLCs”) and requires the registration of LLCs doing business in California. 

The purpose of this article is to provide our clients with the nuts and bolts of the Act and some of the pros and cons of LLCs relative to other organizational structures. Included below is a chart that compares some of the features of the LLC to traditional forms of doing business.

The following information should assist you in determining whether an LLC structure is appropriate and desirable for your business.

OVERVIEW

An LLC is a hybrid form of organization that combines the pass-through tax treatment and management flexibility of partnerships with the limited liability protection and financial flexibility of a corporation, without imposing many of the restrictions applicable to part­nerships and corporations.

An LLC must have two or more members, which may be individuals, partnerships, corporations, trusts, estates, associations, LLCs or any other entities, whether domestic or foreign. The Act provides that an LLC may engage in any lawful business activity other than the banking business, the business of issuing policies of insurance and assuming insurance risks, or the trust company business.

 The Act further provides that LLCs may not render any type of professional services for which a license, certification or registration under the Business and Professions Code or the Chiropractic Act is required. Businesses that provide certain professional services may be organized as limited liability partnerships (“LLPs”) under the California Uniform Partnership Act or as professional corporations under the California General Corporation Law.

 

LLCs may be attractive to businesses that have traditionally been organized as partnerships, such as real estate, oil and gas, research and development and other entrepreneurial business ventures. LLCs generally will not be appropriate for existing corporations or businesses that have or want to raise capital through the public or venture capital markets.

                                                       COMPARISON OF  LLCs,

                                          PARTNERSHIPS AND CORPORATIONS

 

 

 

 

California LLC

 

Limited Partnership

 

S Corporation

 

C Corporation

 

Restrictions on Number or Type

of Owners

 

2 or more members required. LLC may not render professional services.

 

At least one general and one limited partner.

 

Limited to 75 share-holders.

 

No.

 

Liability of Owners

 

Limited to the liability of a shareholder, officer or director of a corporation.

 

General partner(s) have unlimited liability, and limited partners have limited liability if they do not actively participate in the management of the limited partnership.

 

No personal liability absent extraordinary circumstances, such as misconduct, breach of fiduciary duties or inappropriate distributions.

 

No personal liability absent extraordinary circumstances, such as misconduct, breach of fiduciary duties or inappropriate distributions.

 

Active Involvement  of Owners in Management

 

All members may participate.

 

Limited partners are generally not permitted to be actively involved in management without jeopardizing their limited liability protections.

 

Shareholders may participate; however, corporate formalities can make participation of all shareholders unlikely or less active.

 

Shareholders may participate; however, corporate formalities can make participation of all shareholders unlikely or less active.

 

Flexibility

in Determining Economic Rights of Owners

 

LLCs can have an infinite number and types of economic and other interests.

 

Limited partnerships can have an infinite num­ber and types of economic and other interests.

 

Limited to one class of stock.

 

Corporations can have multiple classes and series of stock and equity interests.

 

Pass-Through

Tax Treatment

 

Yes for federal income tax purposes unless election for corporate tax treatment made. Yes for California income tax purposes provided that entity has no more than two of the four relevant corporate characteristics.

 

Yes for federal income tax purposes unless election for corporate tax treatment made. Yes for California income tax purposes provided that entity has no more than two of the four relevant corporate characteristics.

 

Generally yes.

 

No, corporations and their shareholders are subject to taxation at both the corporate and the shareholder level.

 

Franchise and

Other Taxes

 

$800/year plus yearly tax based on total receipts (i.e.; based on gross receipts before any deduct-ions, salaries, costs, etc.) .

 

$800/year.

 

1 1/2% state tax on S Corporations. Is subject to the $500 or $800/year minimum franchise tax. May also be subject to tax for built in gains and excess passive income if was previously a C corporation or the survivor in a reorganization with a C corporation.

 

$500 or $800/year. C corporations generate taxes at the corporate and shareholder levels. C corporations may also be subject to personal holding company taxes and taxes on accumulated earnings.

 

Special Allocations

of Income and Loss

 

Yes.

 

Yes.

 

No.

 

No.

 

Term of Entity

 

Determined by agreement.

 

Determined by agreement.

 

Perpetual.

 

Perpetual.

 

 

An LLC is a hybrid form of organization that combines the pass-through tax treatment and management flexibility of partnerships with the limited liability protection and financial flexibility of a corporation, without imposing many of the restrictions applicable to partnerships and corporations.

 

LIMITED LIABILITY

 One of the most attractive attributes of LLCs is that members and managers of LLCs are provided the same limited liability protections afforded shareholders, officers and directors of corporations. 

 The Act provides that a member or manager will not be personally liable for the debts and obligations of the LLC absent extraordinary circumstances, such as a breach of fiduciary duties, inappropriate distributions or other misconduct. The concept of “piercing the corporate veil,” applicable to corpo­rations, is applicable to LLCs.  An LLC's failure to follow formalities relating to meetings will not, however, be considered as a factor in determining if the members or managers should be held personally liable.

FINANCIAL FLEXIBILITY

 Another attractive feature of an LLC is that it provides great flexibility in defining the members’ interests in the profits, debts, losses, deductions, credits, distributions, assets, liabilities and other economic interests of the LLC.

 An LLC, unlike an S Corporation, can have an infinite number and type of interests that vary in terms of economic interests, man­agement rights, contribution obligations, participation rights, rights on dissolution, transfer rights and many other rights.

 Unless otherwise provided in the articles of organization or operating agreement, members of an LLC are permitted to make capi­tal contributions in cash, property, services rendered or a promissory note or other binding obligation to contribute money or property or render services. In contrast, a corporation’s ability to contribute future obligations in exchange for stock is substantially limited by California law.

 The financial flexibility of an LLC makes it an attractive organizational form for entrepreneurial and start-up companies, research and development entities, joint ventures and other strategic alliances that want to creatively allocate the economic and management rights of the business.

PARTNERSHIP TAX TREATMENT

 The primary reason that LLCs are an attractive form of organization is that, if properly structured, an LLC and its members can take advantage of the pass-through tax treatment applicable to partnerships and their partners. This means that a properly structured LLC, unlike a corporation, can avoid the entity-level taxes applicable to corporations, and the LLC's members may, subject to certain restrictions, claim the losses of the LLC.

 The most significant disadvantage of an LLC over a limited partnership or a corporation is that the members of an LLC face greater exposure to liabilities for self-employment taxes. Additionally, an LLC may not be able to use the cash method of accounting.

 Like partnerships but unlike corporations, an LLC generally can liquidate without adverse tax effects to its members, can avoid accumulated earnings and personal holding company taxes and is not subject to unreasonable compensation disallowances. Although limited partnerships provide many of the same tax advantages as LLCs, the requirement that there be at least one general partner with unlimited liability and the potential for the limited partners to lose their limited liability status make the LLC a more attractive alternative in certain circumstances.

S Corporations likewise provide many of the pass-through tax advantages of LLCs and partnerships; however, an S Corporation is saddled with restrictions on the number and 

 

A properly structured LLC can avoid the entity-level taxes applicable to corporations, and the LLC’s members may, subject to certain restrictions, claim the losses of the LLC.

 

 qualifications of shareholders and can have only one class of stock. An LLC may also be preferable to an S Corporation because, unlike an S Corporation, an LLC is permitted to specifically allocate income or loss to its members, there are no penalty taxes for built-in gains and excess passive income, the basis of an LLC’s assets can be adjusted on the death or withdrawal of a member, and an LLC is entitled to basis for the LLCs debt even though the debt is non-recourse against the member.

 For federal income tax purposes, an LLC will receive the favorable partnership tax treatment outlined above unless an election is made to have corporate tax treatment. In order for an LLC to receive the favorable partnership tax treatment outlined above for California income tax purposes, the LLC must be properly structured. For California tax purposes, an LLC will receive favorable partnership tax treatment only if it does not possess more than two of the following four corporate characteristics: (i) limited liability; (ii) centralized management; (iii) free transferability of membership interests; and (iv) continuity of life. If an LLC possesses three or more of these characteristics, it will be taxed under the California tax laws as a corporation.   

Because it is fairly safe to assume that an LLC will have the limited liability attribute, great care must be taken in defining the rights of an LLC’s members and managers to avoid having more corporate characteristics than partnership attributes. For instance, if an LLC is to be managed by designated managers rather than its members, there may be centralized management. If the members modify the default provisions of the Act relating to the transferability of member interests or the admission or withdrawal of members, the free transferability characteristic may exist. Likewise, if an LLC does not provide for dissolution at a particular time or upon the occurrence of certain specified events, such as the death, disability, bankruptcy, removal or withdrawal of any member, the LLC may have the corporate characteristic of continuity of life.

 

 

If an LLC is not properly structured, and instead possesses three or more of the applicable corporate characteristics, it will be taxed under the California tax laws as a corpora­tion.

 

Although the Act provides default provisions  designed to protect the partnership tax treatment of an LLC, in many cases the default provisions will and should be modified by an operating agreement tailored to the unique needs of the LLC’s members.

Consequently, competent and knowledgeable legal, tax and accounting advice is extremely important in helping to protect the LLC’s preferential partnership tax treatment.

FRANCHISE AND OTHER TAXES

A California LLC is required to pay an entity level tax to the Franchise Tax Board of $800 per year* and, if the LLC’s gross receipts equal or exceed $250,000 for a particular year, an additional fee for such year, ranging from $500 to $4,500 determined based on the LLC’s gross receipts during such year. This graduated tax on gross receipts is payable even if the LLC has losses and may be higher than the 1.5% California tax on S Corporations or the $800 minimum tax applicable to California limited partnerships.

 

FORMATION

 

An LLC is formed by filing articles of organization, together with a $70 filing fee (plus an additional $15 fee if filed over-the-counter instead of by mail), with the California Secretary of State and adopting an “operating agreement.”  The operating agreement may be written or oral and need not be publicly filed. Interests in LLCs, like shares in a corporation and interests in a limited partnership, may be considered securities, subject to regulation under the federal and California securities laws. Consequently, such interests should not be sold or offered for sale without careful consideration of applicable laws.

_________________

 *   Certain “qualified new corporations” that meet gross receipts or tax liability limitations and that do not have 50% or more of their stock owned by another corporation may qualify for a reduced prepaid minimum tax of $300 for their first year and a reduced minimum tax of $500 per year for subsequent years.

CONVERSION OF EXISTING ENTITIES INTO LLCS

 The Act provides that existing business entities such as partnerships and corporations can be converted into LLCs either by merger or contributions. Generally, a conversion from a partnership into an LLC can be accomplished tax free. A conversion from a corporation to an LLC will, however, trigger the recognition of any taxable gain inherent in the corporation’s assets, which may also be taxable to the corporation if it is a C Corporation and to the shareholders if it is an S Corporation. The conversion of a C Corporation may also give rise to capital gain tax liability for the shareholders.

 Because conversions to LLCs can have significant tax consequences and because the consent of landlords, lenders and other third parties may be required to effect such conversions, it is incumbent on any business contemplating a conversion to consult with competent tax, legal and accounting advisors.

 MANAGEMENT

 The owners of an LLC, generally referred to as its “members,” can elect in their articles of organization to have specified managers, who may, but need not, be members, to oversee the operations and manage the affairs of the LLC. The Act further permits an LLC to appoint officers and to selectively delegate the rights and duties of the LLC to its members, managers, officers and other agents without jeopardizing the limited liability protection of members and managers.

 

Because conversions to LLCs can have significant tax consequences and because the consent of landlords, lenders and other third parties may be required to effect such conversions, it is incumbent on any business contemplating a conver­sion to consult with competent tax, legal and accounting advisors.

 

If the members have not elected to have the LLC managed by specified managers, the Act provides that the LLC shall be managed by its members. If the LLC is managed by its members, each member will have the authority to act on behalf of and bind the LLC in connection with third party agreements. If the LLC is managed by designated managers, only such managers will have the authority to act on behalf of the LLC.

 Unless otherwise provided in a written operating agreement, the fiduciary duties of managers to the LLC and its members are those of a partner to the other partners and the partnership. The fiduciary duties of members in a member-managed LLC are likewise those of partners in a partnership.  

The fact that members may be actively involved in the management of an LLC, without jeopardizing their limited liability status, provides a significant advantage over limited partnership structures. In a limited partnership, the general partner(s) have unlimited personal liability for the debts and obligations of the partnership, and the limited partners are generally prohibited from becoming actively involved in managing the limited partnership. 

The fact that members are permitted to actively participate in management also differentiates the LLC from corporations in which the shareholders generally are passive investors.

 The Act provides members of an LLC great flexibility not only in determining who will manage the LLC, but in defining the manner in which the LLC will be managed and the voting rights of its members. The Act provides that a written operating agreement may provide voting rights to its members on a per capita, number, financial interest, class, group or any other basis. If no voting provision is contained in the articles of organiz­ation or written operating agreement, the members shall vote in proportion to their interests in current profits of the LLC.

 Unless the articles of organization or a written operating agreement otherwise provides, unanimity is required to continue the business after dissolution, to transfer membership interests, to admit new members and to amend the articles of organization or operating agreement.

 

 

LLCs provide significant flexibility to their members in terms of who manages the LLC and how it is managed, as well as great flexibility to define the mem­bers’ respective rights.

 

Although members are given great flexibility to define their respective rights and obligations in the articles of organization and operating agreement, the following provisions of the Act cannot be altered: (i) the definitions contained in the Act; (ii) a member’s right to challenge the reasonable-ness, at the time the operating agreement was entered into, of the termination of an interest and return of capital contribution provisions of the operating agreement; (iii) the requirement that at least a majority in interest of the members approve any amend­ment of the articles of organization, a merger or a dissolution of the LLC; (iv) the rights of members to inspect the books and records of the LLC and to receive any statutory annual financial reports; and (v) the right of a member under an obligation to provide services to the LLC to withdraw from the LLC.

 Certain other provisions, such as the fiduciary obligations of a manager, the members’ power to modify the operating agreement and the voting rights of members may only be modified by the articles of organization or a written operating agreement.

 Because the Act provides members with considerable freedom to define their rights and because the default provisions provided in the Act may not reflect the desires of the members, the rights and obligations of the members and the managers should be carefully considered and expressly provided for in a written operating agreement.

 

TRANSFERABILITY OF INTERESTS

 Unless the operating agreement otherwise provides, a member’s economic interest may be freely transferred without jeopardizing the limited liability status of the LLC. A member’s non-economic interests, such as voting and management rights, however, can only be transferred to a person that is formally admitted as a member of the LLC. The Act provides members with a fair amount of latitude in determining the admission requirements of members.

 WITHDRAWALS

 The Act provides an LLC with significant freedom to define the withdrawal rights of its members. The operating agreement may provide that a member may not withdraw a contribution prior to dissolution. If the operating agreement is silent with respect to the withdrawal of a member’s contribution, the withdrawing member will be entitled to receive the fair market value of that interest within a reasonable time after withdrawing.

 DISSOLUTION

 A stated term is not mandatory under the Act; however, if there is a maximum term, it must be stated in the articles of organization. In order to protect the partnership tax treatment of the LLC for California income tax purposes, the articles of organization or operating agreement should provide for technical dissolution of the LLC upon the occurrence of specified events. Until further elaboration, the specified events should include the death, disability, bankruptcy, removal or withdrawal of a member. Notwithstanding this technical dissolution, the remaining members can elect to continue the business of the LLC.

The default provision contained in the Act provides that an LLC shall be dissolved upon the first to occur of the following:  (i) the time specified in the articles of organization or written operating agreement; (ii) upon the occurrence of events specified in the articles of organization or written operating agreement; (iii) by the vote of a majority in interest or such greater vote as specified in the articles of organization or written operating agreement; and (iv) unless otherwise specified in the articles of organization or written operating agreement, upon the death, withdrawal, resignation, expulsion, bankruptcy, or dissolution of a member, unless a majority of the remaining members vote to continue the LLC.

 

RECORD KEEPING REQUIREMENTS

 An LLC is required to maintain and make available to its members lists of each member, each manager and each holder of an economic interest, together with information on the contribution and the share in profits and losses of each member and holder of an economic interest. An LLC is also required to maintain and make available to its members its books and records and copies of its tax returns and financial statements for the preceding six years. An LLC with 35 or more members is also required to provide its members with certain financial information on an annual basis, which includes a balance sheet, income statement and change in condition statement. This provision parallels the provisions applicable to California corporations. An LLC, like a California corporation, is required to file an annual report, called a statement of information, with the Secretary of State, setting forth the names and addresses of each member, each manager and the chief executive officer of the LLC.

IS AN LLC THE ENTITY FOR YOU?

 LLCs provide a provocative form of doing business that combines many of the benefits of partnership tax treatment with the finan­cial and management flexibility and limited liability characteristics of corporations. The above chart compares some of the attributes of California LLCs with the traditional limited partnerships, S Corporations and C Corporations.

 Generally, LLCs should be considered by businesses that traditionally have been conducted as general or limited partnerships but want to reduce the liability exposure current­ly faced by their general partners. LLCs are well suited to real estate, oil and gas, research and development and other entrepreneurial businesses.

 The considerable financial and management flexibility of an LLC may also make LLCs a very useful means of forming strategic alliances and joint ventures. LLCs are also a very attractive means of making investments in foreign countries or obtaining investments from foreign countries. LLCs may also be useful as an estate planning tool or an attractive acquisi­tion vehicle in a transaction where the parties are interested in providing divergent distribution, management and voting rights.

LLCs are not, however, the appropriate form of doing business for everyone. LLPs or professional corporations, rather than LLCs, must be used for busi­nesses that render professional services. LLCs generally will not be useful to busi­nesses that are publicly traded or are plan­ning on going public in the near future. LLCs may not be appropriate for businesses that find it necessary to provide their employees with traditional equity incentives, such as incentive stock options, or that require investments from traditional venture capital sources. Lastly, LLCs may not be appropriate for existing corporations, as the potential tax liability resulting from a con­version to an LLC can be considerable if there are built-in gains.

 

The determination of whether an LLC is appropriate for your business will depend on specific facts and circumstances and should be made only after consult­ing with legal, tax and accounting advisors that are knowledgeable about LLCs and informed about your business and its operating, financial, tax and manage­ment history and plans.

 


Remember, LLCs in California are taxed as partnerships and must pay an entity level tax based on the "total income" reportable to California for the tax year. "Total income" means worldwide gross income, plus the cost of goods sold, paid or incurred in connection with the LLC’s business. In 2003, the tax ranges from $900 to $11,790, as follows:  

Total Income from all sources

Fee

Over $250,000, but less than $500,000

$900

$500,000 or more, but less than $1,000,000

$2,500

$1,000,000 or more, but less than $5,000,000

$6,000

$5,00,000 or more

$11,790

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C. Francis Baldwin
chasbaldwin@surewest.net
Updated Wednesday, May 26, 2004